Wednesday, February 13, 2008

There is a New Business Cycle on the Loose...

according to Thomas Polley and Paul Krugman. Thomas tells us that a new business cycle emerged in the 1980s and is defined by "large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth." He also notes that the new business cycle "embeds a monetary policy that... tacitly puts a floor under asset prices." Paul takes a slightly different look at this new business cycle by focusing on its expansionary and contractionary stages. He notes that unlike pre-1983 recessions, the contractionary stage--which he calls a "postmodern recession"--is now more endogenous in nature and occurs as a result of the natural unwinding of economic imbalances. Simply put, these recessions are not being engineered by the Federal Reserve. Paul also notes that while these postmodern recessions are less painful than before, they seem to be more protracted.

I think Thomas and Paul are definitely on to something. However, rather than calling it a new business cycle, I would say it is the same business cycle responding to developments that were not around prior to the 1980s. These developments are (1) widespread financial liberalization, (2) credible anti-inflation regimes, and (e) globalization of the real economy. Claudio Borio and his colleagues at the Bank for International Settlements (BIS) have been writing about these developments for some time. A key message they have been consistently making is that monetary policy and prudential policy as usual are not going to cut it in this new era.

Like a good novel, each phase in economic history has its villains, heroes and defining moments. Often, it is only with hindsight that we can identify them. There is little doubt now that the great villain during much of the postwar period has been inflation… The defining moment, perhaps, was the end of the 1970s, when monetary policy in the leading economy of the globe, the United States, purposefully sought to break the enemy’s back, thereby fostering a more favourable environment for similar battles elsewhere.

At the same time, since the 1980s a new concern, financial instability, has risen to the top of national and international policy agendas. It is as if one villain had gradually left the stage only to be replaced by another… Why has the full “peace dividend” of the war against inflation ostensibly failed to materialise?

[These new] dynamics of the world economy [can be traced] back to the triad of forces mentioned at the outset[:] financial liberalisation, the establishment of credible anti-inflation regimes and the globalisation of the real-side of the economy...

Financial liberalisation may have made it more likely that financial factors in general, and booms and busts in credit and asset prices in particular, act as drivers of economic fluctuations. In particular, financial liberalisation has greatly facilitated the access to credit. It has therefore also increased the scope for perceptions of wealth and risk to drive the economy, more easily supported by external funding. More than just metaphorically, we have shifted from a cash-flow constrained to an asset-backed global economy. Such perceptions are highly procyclical, reinforcing expansions and contractions as they move in sync with the real economy. While these forces are essentially part of the “physiology” of the economic system – the oil that lubricates it – occasionally, they may go too far, and hence become part of its “pathology”...

At the same time, the establishment of a regime yielding low and stable inflation, underpinned by central bank credibility, may have made it less likely that signs of unsustainable economic expansion show up first in rising inflation and more likely that they emerge first as excessive increases in credit and asset prices (the “paradox of credibility”).

Finally, the globalisation of the real economy may have played a dual role. On the one hand, it may have represented a sequence of pervasive positive supply-side “shocks”. Such shocks would tend to raise world growth potential and help to keep inflation down while at the same time encouraging the asset price booms on the back of liquidity expansion…As history indicates, such supply-side-driven deflations are quite benign compared with their demand-driven counterparts. The risk is that, paradoxically, excessive resistance to “good deflations” can, over time, lead to “bad deflations”, if it supports the build-up of financial imbalances that eventually unwind. [i.e. a point that I have repeatedly made on this blog... see here]

Economic historians will no doubt look back on the last twenty years of the 20th century as those that marked the end of a long inflationary phase in the world economy.... And yet, the same decades will in all probability also be remembered as those that saw the emergence of financial instability as a major policy concern, forcing its way to the top of the international agenda. One battlefront had opened up just as another was victoriously being closed. Ostensibly, lower inflation had not by itself yielded the hoped-for peace dividend of a more stable financial environment...

We would like to make three points.

First, posing the question in terms of the desirability of a monetary response to "bubbles" per se is not the most helpful approach. Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. Booms and busts in asset prices... are just one of a richer set of symptoms...

Second, while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment. One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other

Third, achieving monetary and financial stability requires that appropriate anchors be put in place in both spheres. In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory...

I hope influential observers like Thomas Polley Paul Krugman as well as policymakers take note of this work coming out of the BIS.